Reddy's game plan

Back To Basics

The lowest rate for the smallest of the small-scale borrower will now be 8.75 per cent and for the relatively bigger borrower "" between Rs 2 lakh and 5 lakh "" It will be 11 per cent, after a 100 basis point cut.

This is for the first time in about a year that the State Bank of India has sharply cut its interest rates for small-scale borrowers. Just for information, during that period, the bank rate was cut by 100 basis points and the CRR was reduced by 100 basis points. So, what did Reddy do to get the largest bank to drop its priority sector lending rates?

Under the garb of an innocuous review and continuation of his predecessor's policy, Reddy has made his first move to restructure the credit and monetary policy in a fundamental way.

The core of his game plan is look for and institute "innovative location-specific catalytic agents to bridge the gap between banking institutions and the demand for timely credit in rural areas, for investment in working capital and consumption smoothing...in the cause of improving credit delivery" (Mid Term Review of Monetary and Credit Policy, 2003-2004; Para 53).

What Reddy is trying to do is to change the quality of financial intermediation in the system. He is trying to increase the extent to which the financial sector is accessible to the smaller market participants. The idea is very simple: to remove the institutional rigidities and make the transmission of policy impulses smooth and effective.

Instead of trying to calibrate the interest rates, Reddy has done well to recognise the simple fact that since 1991, while traditional development finance has been abandoned, no new credit delivery mechanism has been set up.

As such, the policy has put on the agenda the issue of sectoral distribution of credit. Such a consideration includes specific supply problems, and attention to the corresponding demand pattern in order to ensure that the resource allocation that will be achieved is consistent with the desired income distribution. This is the only way through which monetary policy can address the issue of poverty.

Traditionally, market access has been believed to be a by-product of financial sector deepening. It always assumed that access for the poor and for employment intensive enterprises like small industries would improve automatically if the financial sector remained stable, efficient and competitive. However, the record clearly shows that this has not been the case so far.

Even after creating a plethora of institutions "" Small Industries Development Bank of India, the regional rural banks, district central cooperative banks, National Bank for Agriculture and Rural Development and micro finance institutions "" the average loan amount is a measly Rs 1,300 per poor family. The coverage of the poor has by no means been satisfactory. The system has simply not been able to provide credit to the under-served sectors.

What is needed is not another set of institutions but a change in the approach of monetary policy. For it is the monetary policies together with the market structure that determine whether financial institutions supply resources for investment in the small-scale sectors of the economy where employment elasticity is high.

If Reddy goes ahead on the road that he has cautiously outlined in his first policy, he will have atleast nine more occasions to do so, it will mean that the future credit and monetary policies will be formulated on the basis of the specific issue of the level and change of domestic credit aggregates and the sectoral distribution of credit.

This approach will have major implications on the orientation of monetary policy. For, it will result in treating bank finance rather than M3 as the crucial link between the monetary and the real sides of the economy.

Herein lies the attempt to lay the ground for a framework wherein money supply is not the pivot around which the monetary policy revolves. Instead, the starting point is the management of aggregate demand and its composition in the context of specific supply side rigidities. A mere relaxing or tightening of the levers of liquidity control is no substitute for this.

If Bimal Jalan slipped the Trojan Horse of structuralist macroeconomics in the sanctum sanctorum of monetarism by casting doubts on the stability of the money demand function, it looks like Y V Reddy will unload the entire army by making monetary policy reflect the heterogenities of the real economy and its multi sectoral structure.

haseebd@business-standard.com